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Southbound, oil prices take no prisoners

March 29, 2016

By: Catherine Yoshimoto, Sr. Index Product Manager

It is not a new story, but it’s one that continues to defy even the worst of expectations – oil prices have been testing their southern boundary since mid-2014. At first, the price drop came as a relief to the markets after years of high oil prices narrowed profit margins in almost all areas of the economy. But as prices have continued to fall, the news has not remained positive – except maybe for people who drive an SUV to work every day.

In January 2016, and again in February, prices dipped below $27 a barrel, a level not seen in the last 10 years. Why is this happening and what does it mean for the global markets?

10-Year Daily Spot Prices (US $ per barrel)

Source: US Energy Information Administration, data as of February 22, 2016

Many factors at play are causing a severe mismatch between supply and demand for oil on a global scale. The US has been producing more of its own oil and has been relying less on imports, which has forced other oil producers to turn to Asia to compete for demand there. The competition has forced prices down. In addition, with sanctions now lifted, Iran has resumed crude oil exports and set aggressive production targets for the coming year.

Where is OPEC, you might ask? Well, this group of oil producing countries that should be policing and stabilizing the industry cannot come to an agreement on how to do so, which is only complicating the situation. Reportedly, OPEC is split on whether their long-term strategy should focus on prices or on the stability of the oil market, with Saudi Arabia and its Gulf allies at odds with Iran and other OPEC members. Smaller oil producing OPEC member countries who rely heavily on oil exports, such as Nigeria and Venezuela, are facing off with Saudi Arabia as the drop in prices is handicapping their economies.

Both developed and emerging economies alike are suffering, as measured by a fall in the ICB Oil & Gas Industry by 23.7% in the FTSE Developed Index and by 25.8% in the FTSE Emerging Index for the 12 months ended February 29, 2016 in US dollar total return terms. Oil dependent emerging economies are less equipped to weather this downturn, and Nigeria and Venezuela have had to seek bailouts and to devalue their currencies, with no relief in sight. The more developed oil-dependent economies typically have more resources to weather the storm, but for how long? That is yet to be seen. The drop in prices is certainly being felt by the oil producing companies themselves who have been forced to cut their workforces and to reduce or eliminate spending on exploration while sitting on a glut of supply, which has affected states along the US Gulf Coast region such as Texas.

Against this backdrop, how have broad equity markets responded? Below I have compared the FTSE All-World, Developed and Emerging Indexes with their ex Fossil Fuels index counterparts. The ex Fossil Fuels indexes have been designed to exclude companies that have a certain revenue and/or reserve exposure to fossil fuels, which reduces the impact of the volatility in oil prices. Against the backdrop of falling oil prices, over the 1-, 3- and 5-year periods ended February 29, 2016, the ex Fossil Fuels indexes have outperformed their market cap-weighted counterparts.

Many market participants believe low oil prices are here to stay for the foreseeable future. This has significant implications for oil companies, oil producing countries, and global markets as a whole. The markets are waiting for a sign of a turnaround and until that sign comes, there really is nowhere to hide.

Source: FTSE Russell, data as at February 29, 2016. 3- and 5-year returns annualized. Past performance is no guarantee of future results. Certain returns shown reflect hypothetical historical performance. Please see the end for important legal disclosures.

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